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April 04, 2008

The Big Picture on Movie Studios

With all the writing I do on the movie business, sometimes I fear that I miss the big picture. Weekly box office or holiday DVD sales can be important factors in short-term trading of movie-related stocks but the long-term trends are less volatile and more important for a fundamentally based investor like me.

With that in mind, a recent report on the major film studios produced by Michael Nathanson of Bernstein Research caught my eye. The report concluded that the film business offers low single digit revenue growth over the next five years but could provide a somewhat greater level of operating income growth if (1) other studios follow Disney's lead and restructure their business models, and (2) new digital distribution channels emerge providing incremental revenue growth, much of which would come with higher margins.

Investors have generally valued film studio profits at a discount due to the unpredictability of the movie business. The discount has expanded recently as the home video market, the primary driver of studio revenue growth for the past three decades, rapidly matured. If revenue growth picks up slightly and operating margins expand, investors may narrow the discount in the coming years. This would be bullish for Disney, News Corp, Time Warner, Viacom, and Lionsgate....

....The major entertainment companies are giant conglomerates. Nevertheless, the film business is material to each. Based on Bernstein estimates and reported results, in 2007, film revenues represented 22% of News Corp, 20% of Disney, and 38% of Time Warner's non-cable revenue (TWX is almost certain to separate its Cable business, Time Warner Cable, later this year). Viacom's Entertainment segment, which is primarily Paramount, represented 41% of total corporate revenue last year.

The real value added from the Bernstein report was a summary of U.S. Consumer Spending on Movie Products from 1981 through 2007. In 2007, total spending was over $40 billion. Given higher international box office but a lesser developed home video and pay TV market it is probably fair to assume that worldwide spending on movie markets is more than twice the U.S. figure.

Over the past five years, growth in spending on movie products has decelerated sharply to just 2% per year. In the 1980s, growth was in the upper teens but slowed to the mid-single digits in the 1990s. Rapid growth in 1980s was due to the maturing of the movie rental business, the beginning of the home video purchasing boom, and the emergence of pay TV networks like HBO as buyers of studio output. DVD purchases took over as the growth engine in the 1990s with accelerating growth from 2000 to 2005 before the much discussed slowing in the DVD market took hold.

Today, DVDs are a no growth business, rentals are falling, the box office rises only by price increases, and pay TV channel purchases of films are flat. In other words, the revenue growth drivers for the major film studios offer little or no growth.

The future of film studio operating profits is not quite so bleak, however. First, there is some hope that revenue growth could pick up. Blu-ray's victory in the next generation DVD war might lead to a pickup in home video revenue from the combination of higher priced DVDs and some library replenishment. New distribution channels like video-on-demand, iTunes and other movie download services purchases, iTunes and other movie download rentals, and internet streaming all could emerge as incremental revenue drivers even as they replace current physical purchases and rentals.

Maybe more importantly, profit margins on digital distribution should be significantly higher given the lack of need for packaging and store distribution. Finally, the upgrade of movie theatres to digital and 3-D could provide a small boost to studios form higher movie ticket prices and distribution of non-movie content like concert films.

There is also some hope that margins could improve from management initiated restructuring of film studio business models. In recent years, Disney has produced the best EBITDA growth in films even though its revenue growth has been quite modest. The company's success has not been the result of simple cost cutting but rather a reworking of its business model for feature film production. The Pixar acquisition certainly played a factor but beyond that Disney is producing fewer films focusing primarily on family friendly films that play to the strength of its brand. News Corp has followed a similar path and also produced strong double digit operating income growth.

Other leading studios including Viacom's Paramount, Sony Pictures, MGM, GE/NBC's Universal Pictures, and Lionsgate have not produced results as good as Disney or News Corp. Looking ahead, given a continuation of slow top line trends and challenges presented by new distribution channels, these studios are likely to undertake similar business model restructuring.

No amount of restructuring can overcome the inherent volatility in film production. Disney has been fortunate to have the Pirates of the Caribbean franchise while Paramount's poor performance can be traced to a string of years with below historical market share and an inability to launch new franchises that produce sequels. Nevertheless, the outlook for improved operating income growth and return on investment for the studios and their corporate parents is real and that would be especially bullish for Time Warner and Viacom given their below average profitability.

For investors, the key takeaway is that the incremental perception of the movie business could improve and that is a bullish arrow in the quiver for Disney, News Corp, Viacom, Time Warner, and Lionsgate.

Posted by Steve Birenberg at April 4, 2008 11:02 AM in Box Office